A grantor retained annuity trust (GRAT) is an estate planning tool used to minimize taxes on large gifts between family members. In a GRAT, an irrevocable trust is created for a specific period of time, and an annuity is paid to the grantor every year. When the trust expires after the last annuity payment is made, the named beneficiaries receive the assets in the trust. There is little to no gift tax applied to any assets acquired from a successful GRAT.
When a grantor creates a GRAT, they contribute assets but still have the right to receive the original value of those assets. They also have the right to earn a rate of return specified by the IRS. When the GRAT’s term expires, any leftover assets are handed out to the beneficiaries that the grantor named in the trust. Beneficiaries essentially receive the appreciation of the assets minus the IRS return rate, also called the 7520 rate or hurdle rate.
Grantor retained annuity trusts are good options for those who wish to pass on their wealth to family members while lowering their tax liability. However, choosing between a short-term GRAT and a long-term GRAT can mean the difference between a successful trust and losing a lot of money. It is essential to consult a team of professional estate planning attorneys when creating a GRAT. If you have questions or need assistance, call our law office today at 510-901-5375.
What is a Short-Term GRAT?
Short-term GRATs, also called “rolling GRATs,” are popular strategy choices. Many individuals choose to create multiple shorter-term GRATs to roll their principal through numerous trusts. This gives the principal a longer time in the market and more of a chance to grow in a short time period.
To set up a short-term GRAT, grantors must specify that initial distribution payments roll into subsequent trusts instead of being returned to the grantor themselves. The grantor will receive more significant distributions in the final years of the cumulative term. Having multiple short-term GRATs makes it much more likely that at least one will succeed. As the annuity payments are made, they can be directed into the successive GRATs to keep establishing funding.
Many people prefer short-term GRATs to account for market volatility. For riskier investments, like stocks, short-term GRATs are a good option. Because new GRATs are funded each year and invested in the market at lower prices, the funds have the potential to take advantage of a market reboot.
A disadvantage of short-term GRATs is that the hurdle rate is not locked in. As new GRATs are established, this hurdle rate could increase. However, as long as the assets in the GRAT outperform the hurdle rate, they can still be successful.
What is a Long-Term GRAT?
A long-term GRAT is a trust with a longer term rate, typically between two and ten years. Long-term GRATs are less popular but make sense in certain financial situations. For long-term GRATs, the hurdle rate can be locked in for a longer period, meaning the assets have a higher chance of success. Since the grantor sets the term rate, they must try to estimate how long it will take for their assets to grow. The more a trust can grow over a longer period, the higher the remaining balance is to be passed on to beneficiaries.
What Are the Risks of a GRAT?
While GRATs can be effective estate planning techniques, there are inherent risks to be aware of. Before you create a GRAT, consider whether the risks are worth the reward.
Below are some of the significant risks of creating a GRAT:
For a GRAT to be effective, the grantor must survive past the expiration of the GRAT term date. If the grantor passes away before the expiration, all assets and any appreciation return to the grantor’s estate and will be counted toward estate tax calculations. A short-term strategy can minimize this risk but not eliminate it completely.
Generation-Skipping Transfer Tax
GRATs can reduce some tax liability, but they are ineffective against the generation-skipping transfer tax (GSTT). Grantors can avoid the GSTT by allocating the assets to their children instead of their grandchildren. There are other estate planning tools you can use to avoid the GSTT while still allocating money to future generations, but a GRAT is not one of them.
The IRS currently permits GRATs and their various estate planning features. However, GRATs are very powerful tools, and many administrations have proposed restrictions against them. While none of these restrictions are currently in effect, there is a chance that GRATs may not be sustainable or viable options in the future.
Lack of Appreciation
When creating a GRAT, the grantor assumes that the assets will contribute more than the hurdle rate set by the IRS. The grantor gets their original assets back if assets do not outperform the hurdle rate. In this scenario, the grantor would lose money in setup fees and transfer fees to receive no reduction in tax liability.
Can an Estate Planning Lawyer Help Me?
GRATs are a powerful estate planning tool that many people use to pass on their wealth. Choosing between a short-term and long-term GRAT is a crucial decision that can impact your entire estate plan. At The Singh Law Firm, our team of estate planning attorneys will review your estate and make a recommendation based on your personal and financial goals. We will also help you set up a GRAT and monitor it to ensure it remains in your best interest. If you have questions about GRATs or want to establish one today, contact our team by calling 510-901-5375.